Carried Away, Yet Again

Speculative frenzies seem inevitable. Can anything be done about them? Yes, but not much.

By

James R. Hagerty

Updated Nov. 18, 2010 12:01 a.m. ET

Alex J. Pollock isn't angry about the financial panic that erupted in 2008 and knocked the U.S. economy into the worst slump since the 1930s. Mr. Pollock, a resident fellow at the American Enterprise Institute and a former banker, isn't even looking for someone to blame. In "Boom & Bust," he swiftly identifies the villain—a familiar, sometimes endearing and invariably roguish character known as human nature.

As long as human nature is with us, periodic financial busts should be expected. Within the past decade or so, the U.S. has had two of them: the first involving the crash of dot-com stocks and the second, much worse, occasioned by the sudden realization that not everyone in America could afford a McMansion. Two financial crises in 10 years may seem like carelessness, but Mr. Pollock says that it is close to the norm: "The economic historian Charles Kindleberger, surveying three centuries of financial history, concluded that there has been a crisis about every 10 years." These busts, Mr. Pollock writes, "arise from the intrinsic nature of human financial behavior."

Booms and busts are a necessary part of an economy that thrives on innovation. Progress tends to make us giddy. We "overbuild, overborrow and otherwise make mistakes," Mr. Pollock says. "There is no way to fix this problem, because the future is unknowable. There is no way for government or any other authority to decide in advance which innovations will succeed and which not." Eventually the marketplace "arrives at the correct answer," but that takes time—and sometimes a bust.

It isn't only the fools who get caught up in the speculative frenzies that lead to busts. Many of the smartest people succumb. Even the brightest, who fancy themselves wiser than the madness of mere crowds, want a piece of the action. "There is nothing so disturbing to one's well-being and judgment as to see a friend get rich," Mr. Pollock observes. In boom times, "previously conservative investors get to feeling that they are suckers to miss out."

As more and more people make lots of money, the soundness of their investments seems to be confirmed. Creditors feel reassured and so make more money available to finance further folly. Of course, the more astute investors realize that the party will end sooner or later, but they assume (often incorrectly) that they will get out in time.

ENLARGE

Boom and Bust

By Alex J. Pollock (AEI Press, 93 pages, $9.95)

Those who recognize that a bubble is forming often underestimate the consequences. During the housing boom of recent years, many bankers, Realtors and builders understood that prices couldn't keep rising so fast and might well fall, at least in some places. Few believed that prices would plunge across most of the nation or that mortgage defaults would become so common as to lose their stigma.

Of course, some ultraconservative people do manage to resist these manias entirely. But such people may be so risk-averse that they miss out on all opportunities to get rich. (Mr. Pollock had his own clashes with risk-averse regulators when he was CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004 but he is silent on those episodes.)

Just as busts are inevitable, so are government bailouts. No politician "is willing to take the chance of going down in history as the one who stood there and did nothing in the face of financial collapse," Mr. Pollock writes.

So what's to be done? Not much. Still, the author does have a few suggestions. Keep government intervention "as limited and temporary as possible." Fannie Mae was created to address what was seen as a temporary shortage of funding for home mortgages in the 1930s. But rather than being phased out when the economy recovered, Fannie kept expanding and was joined by another government-backed mortgage firm, Freddie Mac. Soon they dominated their market. By the time Fannie and Freddie needed a bailout in 2008, they had become a big part of the mortgage problem rather than the solution.

Another idea: Simplify disclosures to mortgage borrowers. The hundreds of pages of legalistic contract language signed by borrowers are virtually impossible to read or comprehend. Federal regulators last year came up with a three-page summary of the key terms and risks. Mr. Pollock has long called for a single-page summary.

Lenders should also grow more conservative as asset prices rise, requiring larger down payments. During the recent housing bubble, the opposite happened. As house prices soared, lenders typically found ways to shrink the minimum down payment—and many congratulated themselves for this "innovation."

Mr. Pollock cautions that we should not expect much of the reform legislation that inevitably follows busts: "Every reform requires another reform to address the effects of the prior one—and on ad infinitum." Somewhat less persuasively, he recommends the creation of a "systemic risk advisor," a body that "should be overseen by a board with deep experience" and "have an insightful and articulate executive director and a small staff with top talent." This body would be "free to speak its mind" to Congress, the White House, regulators and other concerned parties about dangers building up in the markets. Among other things, it would "keep an eye out for signs that risky behavior is coming to be considered 'normal.' "

Alas, risky behavior is normal, as Mr. Pollock makes clear elsewhere in "Boom & Bust," and any such warnings would likely go unheeded—until it was too late.

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